The Relationship Between Money and Prices

The quantity theory of money and its accompanying equation of exchange are
generally accepted as defining the relationship between money and prices.
The equation has been expressed a number of ways, always including "velocity
of circulation", which is a variable essential to balance the equation.

Few disagree with the simple premise that an increase in the quantity of money
tends to increase prices; the mistake is to try to tie the relationship mathematically,
because it rides roughshod over what actually happens. Not all prices rise
at the same time, nor do they rise evenly. Furthermore, the equation of exchange
cannot differentiate between price changes that emanate from demand for goods
and those that emanate from changes in preference for money - two effects
that can produce very different results. These unknowns are effectively wrapped
up in that catch-all, velocity of circulation.

Aprioristic theory tells us where the error lies. People make a choice to
allocate their income between current consumption and savings for the future.
The most they can do without incurring debt is spend their earnings once.
In practice most income is spent on consumption, but some is put aside for
savings, and those savings are lent on through financial intermediaries to
businesses for investment. Savings end up being spent on capital goods and
working capital, instead of immediate consumption, but they are still spent.

If there is an increase in the quantity of money it is spent by those that
first obtain it, but the same rule applies: they can only spend their money
once. How that increase is spent determines which prices will tend to rise.
Furthermore demand for goods can change as the quantity of currency and bank
credit changes and consumers can also change their preference for money by
hoarding or dishoarding only marginal amounts of cash. It is these factors
that govern the relationship between money and prices. Therefore, the number
of times a unit of account circulates over a given time is a red herring.

The fallacies behind the equation of exchange are more fully exposed in the
case of a fiat currency, which unlike gold has no intrinsic value at all.
What it will buy is set by its domestic acceptability as a money substitute
amongst those that use it for transactions, and by its external value in the
foreign exchanges set by those that don't. Its purchasing power boils down
to a matter of confidence and nothing else; therefore velocity is meaningless.

Consider the Icelandic krona's dramatic fall in purchasing power in October
2008. According to the equation of exchange, the sharp increase in domestic
prices that followed must be the result of an expansion in the quantity of
money and/or an acceleration of velocity of circulation. What actually happened
was simply a collapse in the purchasing power of the krona that originated
in the markets, which had nothing to do with any monetary equation.

Velocity is an invention by economists to balance an equation conjured out
of their own imagination, instead of understanding that the purchasing power
of today's fiat currencies is governed solely by the confidence placed in
them. And because they have no intrinsic value, the quantity theory itself
is a wholly inadequate explanation of the relationship between fiat money
and prices.

Alasdair Macleod runs FinanceAndEconomics.org,
a website dedicated to sound money and demystifying finance and economics.
Alasdair has a background as a stockbroker, banker and economist. He is a
Senior Fellow at the GoldMoney
Foundation.

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